If you've got the cash flow and you've paid your mortgage down, investing in property can be a wise move.
Conventional wisdom would hold that paying your home loan off quickly and getting yourself out of debt is the wisest financial move you can make. And certainly, for the majority of your home loan term, devoting extra funds to paying down your mortgage is a wise move. But as your home loan nears the end of its term, that extra cash could be used more productively.
Financial expert Noel Whittaker says the effects of compound interest demonstrate why it's a good idea to look for an additional investment as your original loan term comes to an end.
"How compound interest works is that as the loan term increases, small increases in payments make a big difference," he says.
For instance, if you owe $550,000 at 4.5% interest being repaid over 30 years, your monthly repayments will be $2,786.77 and you will pay a total of $453,236.91 interest. If you pay an extra $270 a month, you can take 5 years off the time it takes you to pay your mortgage and you will pay $367,202.21 in interest, saving yourself $86,034.70. To reduce the loan term from 30 to 20 years, you would need to pay an extra $690, taking total repayments to $3,476.77 and paying $285,514.95 in interest. But once the loan term is down to about 10 years, extra payments don’t help borrowers as much as if extra payments were being made on a 30 year loan.
"Once you reach a certain point in the loan term, about 10 years, compounding interest doesn't matter as much any more. Once you reach a 10 year term, you’re better off using your money to invest. If the mortgage is under control, you’ll save little to no interest on upping the payments and you’re missing out on what could have been five to 10 years' growth if you invested in another property," Whittaker says.
Good debt and bad debt
The decision to take on more debt by investing in property might require a bit of a shift in thinking. While Australians currently carry a record level of household debt, younger Australians are keen to get out from under this debt as quickly as possible. A 2018 ING study found that 55% of millennials considering a personal loan placed high value on the ability to repay the loan early.
But, strange as it might sound, not all debt is bad debt. High-interest debt that curtails your cash flow through the form of monthly repayments could certainly be considered bad debt. However, debt taken on to invest in an income-producing and wealth-creating asset, such as an investment property, is debt that's productive.
Buying an investment property rather than paying off your home loan allows you to produce rental income, enjoy tax benefits from negative gearing and eventually see a capital gain from the sale of the property. In this light, taking on a bit of extra debt doesn't seem unreasonable.
Financial Spectrum managing director Brenton Tong had this to add on making up your mind about taking on a second home or investment loan:
"The decision to invest in another property when you already have a home loan is a pretty big decision because you’re taking on more debt. Probably the most important consideration is your financial position at the time when you’re going to be looking at doing that, and the number one factor when you’re looking at your financial position is your cash flow," Tong says.
"You can have an enormous amount of equity in your property and you could almost have your property paid off, but if you don’t have the available cash flow to fund additional debt then you’re going to be putting yourself in harm's way. If, on the other hand, your debt is quite high and your equity is quite small yet you still have an abundance of cash flow, then quite possibly you might be in a position where you can get into property investment much earlier than you think you can."
Comparing home loans is a great way to grow your knowledge about your options.